The current international financial crisis has brought out in a stark way the impact of globalisation. Globalisation spreads both prosperity and distress. The crisis, which originated in the subprime market in the US, has spread to envelop the entire world. Each country is, therefore, trying to decide on the extent of openness with which it is comfortable. However, experts have been warning against countries adopting protectionist policies. International trade in goods and services will thus continue to expand. However, the coming years may see increasing restrictions being put on financial services. Developing countries may not want to see unfettered freedom in the flow of funds.
The current crisis has exposed the weaknesses of the regulatory framework particularly in advanced countries. There is considerable degree of consensus on how the regulatory framework should be reshaped. Some of the key elements that should be integral to a reformed regulatory structure are as follows:
1. It should cover all segments of financial markets. The rigour of regulation must be uniform among all segments to avoid "regulatory arbitrage".
2. Important financial institutions should receive special attention. Apart from additional regulatory obligations, such institutions may be required to conform to stricter and enhanced prudential norms. Large institutions having operations across countries may require coordinated oversight of regulators of different jurisdictions. In fact, there is a proposal to prevent financial institutions, particularly banks, growing beyond a certain size so that the dilemma of "too big to fail" can be avoided.
3. Institutions may be required to set up buffers for bad times. This may entail varying capital adequacy and provisioning requirements according to the phase of the business cycle. They may be allowed to rise and fall with the business cycle.
4. Excessive leverage in banks may be contained through additional supplements to the risk based capital ratio.
Most countries are convinced that reform of the regulatory structure along these lines is very much needed. However, there is no consensus on measures such as levying a generalised tax on financial transactions. There is also no consensus on whether the financial system should have a single regulator or multiple regulators. The recent experience does not provide a unique answer.
Regulatory reforms should also be seen from an international perspective. "Regulatory arbitrage" can occur not only within the country, but across countries. Similarly, systemically important financial institutions in many of the advanced countries are also international in character. They operate in several countries. Hence, regulatory reforms in a globalised world must be more or less uniform across countries.
In the context of the Asian financial crisis of 1997 and the current crisis in the world economy, the role of capital flows and their impact on macroeconomic stability have been critically analysed. Capital inflows, in general, are welcome. They add to the productive capacity of a country. They also lead to the development of financial markets.
However, the problem with capital flows is their size and volatility. When capital flows are large, and fluctuate sharply, they hurt macroeconomic stability. When the inflows are large, there are three options open to policy makers.
The first option is to let the capital flows pass through the foreign exchange markets. This will result in the domestic currency appreciating, with possible adverse consequences on the country’s exports. This will be particularly uncomfortable, if the country already has a current account deficit.
The second option is to absorb the inflows into reserves. If unsterilised, these inflows will lead to an expansion of money supply causing prices to rise. Domestic inflation has its own implications. Apart from this, with prices rising, the real effective exchange rate will rise, even when the nominal exchange rate remains unchanged. If sterilised, some of the consequences of the reserve accumulation can be moderated but this will imply a cost that will depend on the return on foreign exchange reserves and the cost of borrowing. One has to balance the ‘self insurance’ benefit of reserves with the cost.
The third option is to use capital controls to restrict the inflows and stimulate outflows. Capital controls are not that easy to monitor.
In fact, the response to large capital inflows is always in the form of a mixture of the three options. Policymakers may let the domestic currency appreciate to some extent, absorb some part of the flows into reserves and impose some controls on capital inflows. India has done just that in the last decade. While capital controls have lately gained some respectability, they are always seen as temporary measures. In fact, the best policy option in these circumstances is strong economic growth, which can absorb the larger inflows without affecting stability.
The most important lesson from the current international financial crisis is with respect to regulatory framework. The US and the rest of the world have paid a heavy price because of a lax regulatory system. A rigorous regulatory arrangement acceptable across countries is the prime need.
There are, however, lessons for monetary policy and macroeconomic framework as well. A dominant objective of monetary policy is price stability. However, to the extent monetary policy has a bearing on financial stability, it needs to be taken into account. Asset price bubbles can be caused by the actions or inactions of monetary authorities. "Clean up after the burst" is not an appropriate policy. The recovery process from the deep recession in the developed countries has been complicated by the global imbalances.
There are countries like the US with chronic balance of payment deficits. Equally, there are countries like China with chronic balance of payment surpluses. This, itself, leads to global instability. Coordination of policies among the surplus and deficit countries has become essential.
Coming back to regulation, regulatory oversight of financial innovations is necessary. But the regulatory perspective on innovations must not become too restrictive. In short, policy makers must strike an appropriate balance between the need for financial innovations to sustain growth and the need for regulation to ensure stability.
C Rangarajan is chairman, Prime Minister’s Economic Advisory Council.